CHAPTER 4

THE BEHAVIOR OF INTEREST RATES

What are Interest Rates?

• Rental price for money.

• The time value of consumption.

• Opportunity cost.

• Expressed in terms of annual rates.

• As with any price, interest rates serve to allocate funds to alternative uses.

The Real Rate of Interest

• There is a preference for "real" applications for savings such as consumption or real investment.– Real interest rate compensates for delayed

consumption.– The higher the desire for consumption, the

higher the real rate of interest.

The Real Rate of Interest (concluded)

• The real rate of interest is determined by the demand and supply for savings at a given point in time.– The real rate is the price needed to delay

consumption of funds demanded for real investment.– Upward shifts to the right (increases) in demand for

desired real investment cause the real rate of interest to increase.

– If the supply of desired savings shifts upward (increases) to the right, the real rate of interest declines.

Determinants of theReal Rate of Interest

Loanable Funds Theory of Interest

• The level of interest rates is determined by the supply and demand for loanable funds.– The real rate of interest is the long-term base rate of

interest.

– Short-run supply/demand factors and financial market risks affect nominal interest rates.

– The quantity demanded of loanable funds, DL, is inversely related to the level of interest rates; the quantity supplied is directly related to interest rates.

Loanable Funds Theory of Interest (concluded)

• Borrowers demand loanable funds for home building, plant/equipment, and inventory financing.

• The supply of loanable funds available for financial investment may come from decreasing money balances or past savings.

Sources of Supply of and Demand for Loanable Funds

Notice that households, businesses, and governmental units are both suppliers and demanders of loanable funds. During most periods, households are net suppliers of funds, whereas the federal government is almost always a net demander of funds.

Supply of Loanable Funds (SU) Consumer savings Business savings (depreciation and retained earnings) State and local government budget surpluses Federal government budget surplus (if any) Federal Reserve increases the money supply (M)

Demand for Loanable Funds (DU) Consumer credit purchases Business investment Federal government budget deficits State and local government budget deficits

Loanable Funds Theory of Interest Rate Determination

Loanable Funds Theory of Interest Rate Determination

Loanable Funds Theory of Interest Rate Determination

Loanable Funds Theory of Interest Rate Determination

Price Expectations andInterest Rates

• Expected inflation, ex ante, is embodied in nominal interest rates -- The Fisher Effect.– Investors want compensation for expected decreases

in the purchasing power of their wealth.

– If investors feel the prices of real goods will increase (inflation), it will take increased interest rates to encourage them to place their funds in financial assets.

Fisher Effect

• The formula for the Fisher equation is:

inflation. of rate annual expected the

interest, of rate real ther

interest, of rate nominal observed the i

where

111

e

e

P

Pri

Fisher Effect (continued)

• From the Fisher equation, with a little algebra, we see that the nominal (contract) rate is:

• From this equation we see that a lender gets compensated for:– rent on money loaned,– compensation for loss of purchasing power on the

principal,– compensation for loss of purchasing power on the

interest.

ee PrPri *

Fisher Effect (continued)

• Contract rate example for: 1-year $1000 loan when the loan parties agree on a 3% rental rate for money and a 5% expected rate of inflation.– Items to pay Calculation Amount

– Principal $1,000.00

– Rent on money $1,000 x 3% 30.00

– PP loss on principal $1,000 x 5% 50.00

– PP loss on interest $1,000 x 3% x 5% 1.50

– Total Compensation $1,081.50

Fisher Effect (concluded)

• The third term in the Fisher equation is approximately equal to zero, so it is dropped in many applications. The resulting equation is referred to as the approximate Fisher equation and is the following:

ePri

Price Expectations andInterest Rates

• Actual realized ex-post rates of return reflect the impact of inflation on past investments or on investors.– r = i - Pa, where the annual "realized" rate of

return from past securities purchases, r, equals the annual nominal rate minus the actual annual rate of inflation.

– With ever-increasing rates of inflation, investors' inflation premiums, Pe, may lag actual rates of inflation, Pa, yielding low or even negative actual real rates of return.

Three-Month Treasury Bill Rates

-10

-5

0

5

10

15

20

Jan-6

9

Se

p-7

1

Jun-74

Ma

r-77

De

c-79

Se

p-8

2

Jun-85

Ma

r-88

No

v-90

Aug

-93

Ma

y-96

Month-Year

An

nu

al P

erc

en

tag

e R

ate

Nominal Rates Realized Real Rates

Impact of Inflation on Loanable Funds Theory of Interest

Interest Rate Changes and Changes in Inflation

-5

0

5

10

15

20

Jan-69

Sep-71

Jun-74

Mar-77

Dec-79

Sep-82

Jun-85

Mar-88

Nov-90

Aug-93

May-96

Month-Year

An

nu

al P

erce

nta

ge

Rat

e

Three-Month Treasury Bills

Ten-Year Treasury Notes

Rate of Inflation (CPI)

)

Interest Rate Changes and Changes in Inflation (concluded)

• What do we learn from the previous slide?– Interest rates change with changes in

inflation.– Short-term interest rates change more than

long-term interest rates for a given change in inflation.